Reasons for divergence from short-term PPP
The asset market approach
Besides the practical considerations of market imperfections and heterogeneous market baskets, there are also some theoretical arguments for short-run departures from PPP.Building on the efficient hypothesis, the asset market approach to exchange rate determination argues that currencies are assets and that the present value of an asset depends on what it is expected to be worth in the future.An exchange rate is simply the relative price of two assets—the two currencies—and is determined in the same way as the prices of other assets such as stocks and bonds.Hence because the present value of a currency is today’s exchange rate, today’s exchange rate depends on the expected future exchange rate to happen in the overall economy and how this will be reflected in the supply of and demand for foreign currency.In other words, the current spot exchange rate contains all relevant information about the future and is the market’s best estimate of how the exchange rate is likely to evolve.New information that can change the outlook for the future is arriving all the time and is just as likely to be favorable as it is to be unfavorable.Thus, the evolution of the exchange rate is likely to exhibit an element of randomness.The randomness may or may not be related to PPP because the information relevant to the expected future exchange rate includes more than inflation differentials.Elections, natural catastrophes and wars, among many other things, can also influence exchange rates.
The asset market approach is not inconsistent with PPP.On the contrary, it recognizes the importance of inflation differentials on the evolution of the exchange rate.Furthermore, by considering the random element associated with expectations about the future it offers a theoretical explanation of how spot rates can diverge from their PPP equilibrium in the short run.
Overshooting
Another popular explanation for significant short-term deviations from PPP is the Dornbusch theory of overshooting.This theory marries the concepts of PPP, “sticky prices” and the asset market approach.Suppose that PPP holds in the long run but the prices of non-traded goods are sticky and adjust slowly to their new equilibrium level after a disturbance such as a unilateral increase in the domestic money supply.Eventually prices will rise in proportion to the increase in the money supply, and the nominal exchange rate, driven by changes in PPP, will depreciate in proportion to the changes in prices.In the short term, however, the price level increases less than the money supply due to the sticky prices for non-traded goods.The resulting excess supply of money will be spent at least partially on bonds, thereby causing bond prices to rise and interest rates to fall.Because investors have rational expectations and anticipate the eventual depreciation of the currency, they require higher interest rates to offset the depreciation.This is because total expected returns include interest plus or minus the expected appreciation or depreciation of the currency.But current interests are lower than before.Thus, in order for investors to buy domestic assets the currency must overshoot or depreciate to a point below its long-term PPP equilibrium level, from where it is then expected to appreciation.In this way its anticipated appreciation will compensate for the lower interest rates.
The portfolio balance approach
Another explanation of exchange rate determination adds demand functions and equilibrium conditions for bond markets to the traditional monetary approach.This approach, called the portfolio balance approach, assumes that investors desire diversified portfolios and, hence, will hold both domestic and foreign assets.Whereas the monetary approach assumes that bond markets always clear, the portfolio balance approach, through supply and demand functions for bonds and equilibrium conditions setting bond supply equal to demand, shows how bond markets clear.With this modification, the effects of changing bond supplies and demands can have consequences on interest rates and the exchange rate that differ in the short run from what is forecast in the monetary approach.
Suppose, for example, that the central bank buys domestic bonds on the market.This will increase the money base and, through the reserve ratio multiplier, cause an increase in the domestic money supply.Other things being equal, the primitive formulations of the money approach predict that the exchange rate will depreciate by the percentage increase in the money supply.The portfolio approach argues that by reducing the supply of bonds in circulation, the central bank has created an excess demand that will raise bond prices and lower interest rates.Lower interest rates have well known consequences on investment, output and prices that will affect the exchange rate.This implies that at least in the short run the exchange rate can stray from its long-run PPP equilibrium.
Besides the many explanations of short-run departures from classical PPP, some of the observed departures may be due to the statistical problems of evaluating PPP.Price indexes, for example, vary substantially across countries.The goods and services included are not always the same and when they are the same they are not always given the same weight.Changes in the relative prices of the goods that make up the indexes will cause differently constructed indexes to react differently, thereby sending false signals of departures from PPP.
In summary, then, in spite of the evidence of significant short-term departures from PPP, it is clear that there is a strong correspondence between relative rates of inflation and changes in the exchange rate.However, because PPP is not a complete theory of exchange rate determination, the correspondence is not perfect and there is no theoretical imperative to associate departures from PPP with market disequilibrium.